Sunday, July 17, 2016

Implications of “That Was The Week That Was”



Introduction

I am not by nature an Anglophile, but there is much that investors can learn from British History and culture beyond BREXIT. Many years ago there was a television series entitled, “That Was The Week That Was,” or  “TWTWTW” which was a satirical take off on the rather pompous reading of news on British television. As with many theatrical productions from the UK, the concept was brought across the pond and for quite awhile we enjoyed an American version.  Investors last week viewed their own global version of TWTWTW.

One of the standard lessons in geopolitical writings is that war is in effect carrying out policies by other means. Commercial and cultural changes are carried out through international conflicts. I believe that in the future historians will view BREXIT as the beginning of the next phase of global commercial and cultural changes which will dictate different investment policies.

But first we need to live in the present and so on to what may have been a turning point for investors in the TWTWTW.

TWTWTW

I believe that the US stock market action on July 8th, my birthday, was a gift to most equity investors globally. The putative proof of this is the performance of stocks in the last week when the Dow Jones Industrial Average continued to rise to new highs each day and the broader Standard & Poor's 500 rose for four days and just missed a new high on Friday. Some will say the price movement was just a return to a "risk on" attitude. I see it differently for the following reasons:

1.  Instead of the prior stock price leaders continuing to be the performance leaders, it was the laggards that recovered.

2.  Based on stock and bond prices, many of the Index funds also underperformed on a relative basis. (This is not surprising in that most of these indices are anything but truly diversified in terms of quality of issuers.)

3.  In a similar fashion many of the alternative portfolios also under-performed

4.  Many of the non-fully participating institutional and individual investors are complaining that valuations are not at the expected levels for good entry points. They are historically correct, but they are in two traps; first too many financial statements are overstating earnings on a continuing basis. The second trap is that they are only looking at near-term results and at best, next year's expectations not a prolonged view of the future in terms of the issuers and their own needs. (The latter is addressed in the context of the TIMESPAN L Portfolios®.

The Changing Marketplace

Not all is completely rosy. Both the equity and to some extent the high quality fixed income markets are being driven by Exchange Traded Funds (ETFs), and similar vehicles are growing less fast than in the recent past. If the week is an example, ETF investors are riding a bus that is being passed by faster individual cars.

In addition, the structure of the marketplace is changing with capital being constrained by market makers and they are being replaced by hedge funds which from time to time play a similar role of absorbing temporary excessive flows. One can not count on the same level of support in periods of rapidly building tension than in the past. Too many people view volatility as risk and one should expect bouts of volatility which could be as much as six times what we are currently experiencing.

US Treasuries “Risk-Free?”

Global stock and bond markets are tied together and a problem in one can be disruptive to other markets. Government securities, particularly US Treasuries have been viewed as “risk free,” but because of their use as collateral for “carry trades” they can be forced to react to sudden changes in more speculative securities. Hedge fund professionals view that the Treasury market is increasingly crowded with other hedge funds not simple buy and hold players. In other securities we have seen auctions that failed to be completed. Due to changes in the structure of market capital providers it is possible that we could see a US Treasury auction fail. While on a long-term basis this would not be terrible, in a short-term it could shake the confidence of investors in most markets.

While I believe a portion of our money should be focused on the long-term and use future-oriented valuation approaches, I am very  aware that at some point in the future our old valuation techniques will likely determine the winners and losers.   

The Future through BREXIT and Henry V

The BREXIT referendum "leave" vote was carried by the North of England voters. Some of these had ancestors who were the long bow men that won the battle of Agincourt for Henry V. In this battle some 3500 Englishmen defeated 60,000 heavily armored cavalry led by the cream of the French society who were experts with swords and lances. The English archers impacted the French forces before they could close with the English, and thus won the battle and the war by changing to unexpected and better weapons. I believe this is a model for Mrs. May's government.

The combined arsenal includes currencies, tax rates and rules, lower cost of government and a more efficient bureaucracy, The current French President has already commented that the decline in the exchange value of the GBP was “not helpful.” Interestingly that the fall in the value was not led by the government but by a functioning marketplace that many European governments don't trust. Currently the cost of British exports is high because of EU taxes and regulations. In the months ahead, when freed from these burdens, export prices will drop and market share will grow as trade expands with the Western Hemisphere, Asia, and Africa/Mid East. (This could be a bit deflationary, but positive for consumers. Further, this is part of the trend started by the current leadership in China to favor consumers over production workers.)

I suspect that if the UK government can lower its tax burden, more companies will chose to headquarters there. We are likely to see more tax-motivated inversions from both European and US companies. One of the ways governments can lower their costs and improve the efficiency of delivery is to outsource to the private sector much of what they do now. Undoubtedly there will be a fair number of mistakes made and then corrected. Nevertheless, costs will come down and consumers will benefit.

Insufficient Retirement Capital & Other Challenges

Further I am guessing that the demographic problems the developed world is facing where the dependency ratios are rising, and where the number of laborers is becoming insufficient to create retirement capital for the retired will be solved by rapid changes in the guilds that control primary and secondary education. The fundamental issues are that in the modern world, businesses can not hire qualified workers and far too many of them do not understand how to work in a competitive society. The question is not the number of immigrants, but the ability to absorb them into a productive and growing workforce. This may well prove to be the biggest task for the new government, but if any nation can solve it, the Brits have now the best chance, because they must.

The New PM

It is quite possible that the second female UK Prime Minister will, in her own way, be as impactful as the first. I believe she has a good chance to lead the developed countries out of the wish for only 2% growth to multiples of that.

While history does not completely repeat itself, the current situation reminds me a lot of the time when Mrs. Thatcher became the Prime Minister. One of my early and important mentors on the New York commuter train, the late Arnold Ganz, became a real believer in her. Because of Arnie in the 1980s I started to invest in UK financial services companies and their investment trusts (Closed Ended funds). For the most part, some thirty years later they have proven to be a good investment. So today, I am betting that the long bowmen of the "leave" referendum will once again hit their targets against a larger group of “experts.”

Question of the week: Do you now have a view where the US Senate will lead the US?
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Sunday, July 10, 2016

Did Friday Begin a New Up Cycle?



Introduction

Market and economic historians like to date the beginnings and ends of various phases. They usually pick the ultimate peaks and bottoms of a statistical array. When possible I find it more useful to pick a date or a range of dates when attitudes change. If the financial markets are performing their function they should be discounting the future path not purely reacting to late reports of the economy. The problem is to define how far out in the future the markets are discounting. Most of the time markets look to different futures based on their needs for duration and safety of their segments.

Friday could have been such a turnaround in market sentiment. The surprisingly strong markets could have been a function of realizing that in the long-term, Brexit could produce some positive results that the “experts” who were wrong in their referendum forecast were similarly wrong in their completely one sided forecasts as to the consequences of a vote to “leave” the EU.

On Friday, July 8th , two price movements contrary to each other were reached. (This was not in celebration of two birthdays, The Wall Street Journal and my own.)  The S&P 500 came within one point of its all time high price reading a bullish sign. On Friday the yield on the ten year US Treasury hit an all time low. Normally a low high quality bond yield is a sign that investors will accept a very low yield for safety because they fear that the worst is forthcoming. These twin occurrences on the very same day suggest to me two things. First, that different segments of the market are discounting very different futures. Second, that past valuation approaches are no longer working. (In future posts I will raise  questions as to the relevance of unadjusted financial statements.)

Fund Performance Numbers Reveal

On Friday the Dow Jones Industrial Average gained +1.4% and the S&P 500 was up +1.53%. Since the indices are not burdened with either low returning cash or expenses including commissions they often perform better than managed funds. Despite having cash redemption reserves and tactical reserves plus expenses, average Large Capitalization Core Equity funds as well as Large Cap Growth funds equaled the S&P 500 daily performance with the average Large Cap Value funds performing 10 basis points better at 1.63%. My old firm, Lipper, Inc.,  did not provide to The Wall Street Journal an analysis as to the performance of the ETF universe broken down by investment objectives, but it is my impression that the bulk of the ETF assets are in passive Large Cap vehicles who probably did not equal the average performance of the active Large Caps. For those of us who manage portfolios of funds we were pleased to see Mid and Multi-Cap funds on average rise between +1.96% and +1.65%. The big winners of the General Diversified funds on Friday were the Small Caps on average up over 2% led by the Small Cap Value Equity funds +2.25%.

If these relatively better results can be maintained they will answer the rather dour forecasts for the fund industry by Barron’s and McKinsey and some others. Like the Brexit Leave experts they do not study the fund and asset businesses very well. They focus on net redemptions which is the net result of an aging fund ownership population needing more income and perhaps less volatility. These negative reports also highlight poor sales due to the higher profit sales of competing products who over the long-term on average haven’t produced good results.

As someone that invests both in mutual funds and fund management companies, I am delighted to find negative indicators. As I have said in the past, negative indicators tend to be more consistently wrong than positive ones. However, to be fair and balanced I need to remind my readers I could be guilty of confirmation bias which only sees things that favor my point of view.

Brexit Updates

Fitch is reporting that beneath the surface, pre-negotiations are already going on across the channel. Whitehall is already reaching out within the UK government circles and the commercial world to look for experienced analysts and negotiators. We suspect many of the old countries of the Commonwealth are already seeing an opportunity to increase their trade with the U.K. on more favorable terms with the elimination of various EU rules on British trades.

I believe too many people see the local reactions as anti-globalization. I suggest when you again look at the data, one can see a fundamental reaction to expensive governments who impose their social expenditures  on to the commercial world which pass on their costs to the consumers in higher prices. For instance, in the US we are currently seeing wage and benefits rising faster than sales which is causing profit margins to decline. I believe all over the world the costs of big government are depriving consumers money which could help them in addressing both their education and retirement needs which are growing faster than their economy.

Modern Lessons from Europe

As readers may know, I have drawn the parallel between Brexit and the 1848 disruptions. The one person that played the most successful role for the next forty years was Otto von Bismarck, the consolidator of Germany who successfully played on each political side from time to time and maneuvered the other nations brilliantly. He has many great quotes and lessons attached to him. The first is the basis of my continuing analysis of good and bad performance. “Only a fool learns from his own mistakes. The wise man learns from the mistakes of others.” Hopefully these blog posts aid in that effort. The second quote is very useful for most of the world which will go through contested elections from now through the end of 2017: “ People never lie so much as after a hunt, during a war or before an election.”

The third lesson is the failing attempt to unify Europe from the time of Julius Caesar to the present. We should be able to relate to this problem when we look at how many large mergers actually work. Takeovers initially have a better chance but only if in the end they enlist the taken over into the new structure and leadership.

Working Conclusions

Brexit will lead to vital changes in trade, politics, technology and most importantly of all, consumption. From an investment view point we should try to spot as many winners as possible because only some will be long-term winners. Thus an active portfolio management strategy has the best chances of reasonable rewards and relative safety.

Question of the Week:

What are the questions you would like to ask me? 
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All Rights Reserved.
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Monday, July 4, 2016

Lack of Confidence in Brexit Era Could be Costly


Introduction

I am a student of long-term investment performance for our accounts and my family. Some of the money entrusted to us is designed to make future payments many, many years into the future. Thus, I study which are successful and unsuccessful investors and their strategies over long periods of time. In that light I mentioned at a recent meeting of the New York Society of Securities Analysts celebrating the thinking of Ben Graham, the father of value investing, why I believed that the “experts” were wrong that the British would vote to remain within the European Union. They violated my rules for avoiding large losses that I derived from Ben Graham and my old professor David Dodd. The rules are:

A.  Overconfidence (Almost universal belief in an outcome)
B.  Faulty, incomplete, and poorly timed assumptions (Economic only
arguments) - Lack of non-financial milestones (Confusing money bets with bookies and number of bets + % undecided)

C.  The frequency of massive overconfidence in financial history is relatively rare; e.g., “Tulip Bulb” Sub-prime mortgages with house prices never declining. Avoiding those losses are critical to the number one rule of successful investing which is to avoid (big) losses along with the second rule, which is not to forget the first rule.

The First Two Rules Are Not Enough

One could have avoided losses from overconfidence by just moving into an all cash position and one would have saved all or the bulk of one’s capital. But if you stayed in cash you would have missed out on the compounding growth that investors have experienced over many years. Using a no-brainer approach of investing in a market index since 1926, one could have compounded at about 9% which doubles money every 8 years. (This is not a prediction of future returns.)

Our objective relative to the risks assumed is to do better than a mechanical index strategy. However, to beat the index one should analyze the performance of the index compared with actively managed investment accounts. In the periodic market declines, the index declines more than the accounts because first it does not have any cash and second most indices are heavily weighted in favor of the most liquid stocks which typically drop the most as they are the easiest to sell. The reverse is true on the way up from the bottom. The indices have no cash to reduce their rate of gains and are in the most liquid stocks that late-comers plow into.

As a student of investment performance of successful managers, I have noted that they have more confidence in what they are doing than others. Often they are lonely in adopting a particular stance or set of securities. Typically they are not positioned defensively in early stages of what proves to be a rising market. Many times this lonely confidence (compared to a market of little confidence) produces a superior compound growth rate. The superior managers don’t always do extremely well, which is why our portfolios have a number of funds that have characteristics that suggest in appropriate markets that they will do well.

Is Brexit an Opportunity?

Caveat emptor or buyer beware: we can not predict the future. My training at the race track is such to wish most of the time to avoid the betting favorites (weight of money) as well as my contrarian nature suggests that Brexit could well represent a major long-term opportunity for investors around the world.

Why?

There are potential parallels between 2016-17 and 1848 as indicated in last week’s post   There are already eight European elections scheduled plus the re-vote in Austria. Australia finished voting this weekend with the present government weakened. The US will have a new administration and a different makeup of its Senate. There is a likely chance that within Europe there will be Brexit type votes either the in planned elections or in special referenda.

Around the world the existing order is under attack by groups on the right and the left claiming that the politicians and other “experts” have not delivered. Further they claim, governments are too big and therefore expensive and inefficient. Supranational bodies are viewed as even worse, as they are further away from the disgruntled people. In part due to social media, many minorities have expressed unhappiness with majority cultures and are expressing desires for autonomy or even independence. One wonders whether the concept of nationhood will need to change.

The world has changed. Even small companies and to some degree small investors view the world through multinational lenses. In the forthcoming negotiations between the UK and the EC, at the moment the UK has the advantage in that it should not be in any hurry. In the meantime it will be free to develop singular trade deals around the world. At the same time multinational companies and investors will seek out their own best deals. There is a long history of wartime enemies arranging a regular flow of trading between combatants. (I suspect that some in Germany are already at work on this option.) In the eventual final negotiation it would be wise for the UK to have one with the negotiating skills of “The Donald.” This is not a US political judgment, but one that recognizes commercial realities. It would not surprise me if the length of the negotiations is not similar to the twelve-year period between The Declaration of Independence and The Constitution. And that process had the benefit of the Founding Fathers led by Hamilton, Jefferson, Madison, and Monroe.

Perhaps coming out of all this will be a political shift favoring consumption over labor. China is attempting to do this with difficulty. The pro-labor attitude of the existing power structure has not worked. By raising the cost of labor (including benefits), it priced much of labor out of the market to be replaced primarily by automation, if not outsourced production beyond China’s borders. By focusing on consumption the drive will be in terms of price, quality, and safety which can produce a healthier and more satisfied society.

There is Still One Thing Missing.

The two largest economies in the world have been built by risk-takers. In both the US and China, the countries are populated by people who took the risk to move to their present location. Historically in the US, it is important to remember that with the exception of the Native Americans, we all came from someplace else for the past four hundred years. Because we arrived with very little in the way of financial assets, we were, and many of us are still today, risk-takers. This makes us unique among nations at the moment, which will have to be corrected if the Europeans want to catch up to the US.

Pardon a parochial view, but I often view the world through mutual fund glasses. One measure of the risk-taking attitude of investors is the portion of their assets invested in equity funds. On paper, Europe as a whole is the same size as the US economy. As of the end of the first quarter of 2016, the world has invested $16.4 Trillion in equity mutual funds. US registered funds accounted for 60.9%. All of Europe had only 27% in equity funds, including Luxembourg and Ireland which are favored by tax aware global investors outside of the US. Excluding the tax shelter investors, the four European nations with the largest share of the global equity funds were the UK with 4.3%, France 1.9%, Netherlands 1.7% and Germany also 1.7%. The potential of  less expensive and bureaucratic government focus on consumption is great. However, it won’t be achieved if most of the risk-taking comes from US and Chinese sources.

Assets in Equity funds:
as of 3/31/2016
All Equity Mutual funds
100%
US-registered funds
60.9 %
All of Europe?
(including Lux & Ireland)
27.0 %
UK
4.3 %
France
1.9 %
Netherlands
1.7 %
Germany
1.7 %

Source:  ICI



How should one invest in the Brexit Opportunity?

This will undoubtedly be a long and laborious task. In a time-segmented portfolio as in our TIMESPAN L Portfolios®, I would begin with small commitments to International funds which have 40% in Europe and buy more during periodic setbacks. The small fund participation rate in Europe may be an opportunity for financial services investing. I will be happy to discuss privately how we do it in our private financial services fund.    
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Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.